Mid-cycle correction offers value

Eric Knutzen

For some, recent data points to a coming global recession and the end of a business and credit cycle that has already lasted a very long time by historical standards. We disagree. We are reminded of a similar mid-cycle correction in 2011. During this episode, the S&P 500 dropped by 20% peak-to-trough. As a result, we are cautious in our short-term outlook.

But on a 12-month basis we maintain our modest risk-on bias – and in fact we have become even more confident in our medium-term return outlooks given the sell-offs we have seen. This slowdown will eventually offer some attractive entry points to add risk to portfolios, particularly in parts of the credit markets. The key word, of course, is ‘eventually’. Given the recent poor data, we will certainly need to see some manifestation of the increase in credit defaults that has been forecast, and some reratings of BBBs to BBs, before we feel things have bottomed out. The same applies to what is happening with oil: We want evidence of real production cuts from a marginal non-OPEC player (or even an OPEC producer), and signs the rig-count and capex declines in the US are leading to reduced production. Once these are built into the environment – possibly by the summer – we think it will be an opportune time to consider adding risk.

Until then, we are watching carefully for any further signs of deterioration. We still worry most about China, and any significant further decline of the yuan would be the signal to revisit our thesis.

A 10%-plus devaluation would suggest China may be going through a ‘hard landing’, potentially triggering currency wars and global deflation. This is far from our base case, however. Our watchword is caution – but caution in scouting for opportunities over the coming months.